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2015 Priorities for SEC and FINRA examinations and trends in litigation risks

January 20, 2015

On January 6 and 13, 2015, the SEC and FINRA, respectively, issued their 2015 priorities for examinations of registered broker-dealers and investment advisors. Below is a summary of aspects of those notices relevant to most registrants and a brief description of emerging areas of litigation risk associated with some of the issues identified by the Commission and FINRA.

SEC 2015 Examination Priorities

On January 13, 2015, the Office of Compliance Inspections and Examinations (OCIE) published its 2015 examination priorities for investment advisors and broker-dealers. The OCIE identified the following themes for the organization of its 2015 priorities:

  • Emerging issues concerning retail investors, particularly those regarding retirement assets;
  • "Market-wide risks," issues related to most participants in the securities market; and
  • Advancements in the SEC's ability to analyze data to identify illegal activity.

With respect to retail investors and retirement savings, the OCIE identified two trends that shaped its priorities. First, registrants are developing and offering a variety of new products formerly characterized as alternatives that are complex and unique. Second, as "investors are more dependent than ever on their own investments for retirement," the financial industry is offering "a broad array" of information and products for retirement assets. Based upon these developments, the OCIE plans to emphasize the following in their examination of registrants:

  • Appropriateness of commission-based or asset-based compensation arrangements -- specifically, whether the fees charged are in the best interest of the client based upon the intended activity in the account;
  • Sales practices and recommendations concerning the movement and investment of retirement assets;
  • Suitability of recommendations for retirement funds invested in complex or structured products; and
  • Adequacy of branch office supervision based upon the Commission's analytics to identify branches deviating from compliance standards.

As to "market-wide risks," the OCIE identified various "structural risks and trends" that will cause it to focus on various initiatives in its examinations, including:

  • Large firm monitoring for the purpose of assessing risks and maintaining early awareness of developments industry-wide;
  • Examining broker-dealers' and investment advisors' cybersecurity compliance and controls; and
  • Order flow, conflicts of interest and best execution.

Finally, the following examination priorities will be in conjunction with the OCIE's data analytics to identify signs of potential illegal activity: 

  • Identification of recidivist representatives and the firms that employ them;
  • Identification of activities that suggest the registrant is engaging in, or aiding and abetting, pump-and-dump schemes or market manipulation;
  • Use of clearing firm information to identify introducing brokers that appear to be engaging in excessive trading; and
  • Examination of AML programs, particularly of firms that have not filed SARs or have filed incomplete or late SARs or those who allow customers to deposit and withdraw cash and/or provide customers direct access to the markets from higher-risk jurisdictions.
FINRA Establishes Its 2015 Regulatory and Examination Priorities

On January 6, 2015, FINRA issued its regulatory and examination priorities for 2015. As one might expect, some of FINRA's priorities are the same or similar to those identified by the OCIE. FINRA initially sets forth "challenges" in five areas contributing to firms' and registered representatives' "at times compromising the quality of service they provide to customers as well as contribute to compliance and supervisory breakdowns."  FINRA counsels that addressing these challenges will enable firms to avoid the concerns FINRA identifies. The challenges are:

  • "Putting customer interests first" — particularly when the advice concerns vulnerable investors such as seniors or wealth events such as inheritance or individual retirement account rollover;
  • "Firm culture" — firm's highest management should set the tone from the top concerning client interest and best practices and not relegating such important issues to a "compliance" function;
  • "Supervision, risk management and controls" — FINRA emphasizes that firms should have "proactive" supervisory programs and controls and strong supervisory and management systems to prevent  harm to customers;
  • "Product and service offerings" — particularly practices concerning the disclosure and recommendation of new or alternative products; and
  • "Conflicts of interest" — FINRA, like the SEC, focuses upon the conflict of interest concerning fee arrangements that are not in a customer's best interest.

FINRA's 2015 priorities concern key sales practices and financial and operational matters. With respect to sales practice priorities, the following are among the most important to broker-dealers:

  • Products —  Just as the OCIE, FINRA examiners will be scrutinizing the sale of alternative products to retail investors with respect to the level of due diligence of the product, the disclosures to investors, and their suitability.  The products of particular interest will be: (a) interest rate-sensitive fixed income securities, (b) variable annuities, (c) alternative mutual funds, (d) non-traded REITs, (e) ETPs tracking alternatively weighted indices, (f) structured retail products, (g) floating-rate bank loans funds, and (g) securities-backed lines of credit.
  • Implementation of FINRA's New Supervision Rules — FINRA coordinators and examiners will inspect firms for compliance with FINRA's new supervision rules (Rules 3110, 3120, 3150, and 3170).
  • IRA Rollovers and Other "Wealth Events"  — FINRA will focus on firm controls concerning the handling of wealth events such as inheritance, life insurance payouts, sale of business, and movement of retirement funds.  Similar to the OCIE, IRA rollovers will be of particular emphasis because of the dramatically increasing number of individuals with self-funded retirement assets.
  • Excessive Trading and Concentration Controls  — FINRA examiners will focus on firms' supervisory processes, systems and controls concerning how firms monitor for excessive trading and product concentration.
  • Private Placements  — FINRA plans to review firms' private placements to determine whether broker-dealers performed sufficient due diligence of products and have adequate support for suitability determinations.
  • High-Risk and Recidivist Brokers — As the OCIE, FINRA plans to use advance data mining capabilities to identify and remove problem brokers from the industry and to rigorously scrutinize the firms who hire high-risk or recidivist brokers.
  • Sales Charge Discounts and Waivers  — FINRA intends to determine if firms have  adequate systems to ensure breakpoints and sale charge waivers are provided customers when available.
  • Senior Investors  — FINRA examiners will focus on the disclosures and suitability of recommendations for these vulnerable investors.
  • Anti-Money Laundering — FINRA examiners are expected to focus on the adequacy of firms' surveillance of costumer trading, of identification of red flags, and of transfer activity.

As to financial and operational priorities, those generally important to all broker-dealers are:

  • Development and monitoring of funding and liquidity risk management programs, including the accuracy of the price firms assign to securities;
  • Approaches to cybersecurity risk management, including firms' governance structure and processes for conducting risk assessment and addressing the output of those assessments; and
  • Adequacy of supervision of outsourced functions.
Trends in Litigation Risks

Aspects of both the SEC and FINRA's examination priorities reflect a growing risk to broker-dealers and investment advisors of not only regulatory enforcement actions, but customer litigation. There are two trends that present particular challenges to compliance and risk managers. First, in response to customer concern about market volatility and low returns due to interest rates, registrants have been developing and offering to retail customers a variety of alternative products that are marketed typically as arbitrage or hedge-fund styled investments. Many of these products attempt to capture yield and limit risk through complex structures. However, when these products produce losses, registrants increasingly are finding themselves defending the product before skeptical arbitrators or juries as to suitability of particular retail customers participating in difficult to comprehend investments. Second, as the baby boomers retire with their self-funded retirement assets, many will be interested in obtaining returns beyond that offered by relatively safe interest-bearing investments. When losses occur, retirees often look to litigation as a means of restoring their assets and have the advantage of perception before arbitrators or juries, who in hindsight question the wisdom of broker-dealer or investment advisor recommendations that lead to the retirees' woes. Accordingly, firms should take steps to have procedures in place for these situations which provide for supervisory review and careful documentation.

For more information regarding this or any other broker-dealer related issue, please contact one of Honigman's Broker-Dealers and Investment Advisors Industry Group attorneys.

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